Working with Self-Employment Income
Of the all the income sources that need to be verified for affordable housing programs, self-employment income has to be one of the most challenging. There are so many factors to consider when determining income for those who are self-employed:
Is the person self-employed? Is this new business or existing business? Did they file a tax return?
Forms certifying to self-employment can be confusing for the applicant/tenant. It is important for management to have a thorough understanding of the forms they are required to use and the supporting documentation being requested. Required documentation to support self-employment income varies widely and while the following are general guidelines, a review of your state specific requirements is recommended.
Types of Self-Employment
The first step is to determine just what sort of “self-employed” the household member is. Generally, self-employment household members are either:
- Owners of businesses
- Sub-Contractors who are paid by an employer with a 1099
- There are times when the individual is not sure if they are considered self-employed. Processing third party verification and additional clarification will assist in understanding if the applicant/tenant is self-employed or an independent contractor.
Household Employees vs Self-Employment
According to the IRS, applicants/tenants are considered household employees if they provide services in a private residence as a housekeeper, maid, babysitter, gardener, etc. They are considered employees when the work they perform and how they perform it is in the control of the individual who hired them. Applicants in these situations would not be considered self-employed and the employer is responsible for paying federal taxes. However, if applicants/tenants provide these services and consider their work to be their own business (defined below), in addition to the self-employment form, request additional documentation from the individual hiring the applicant/tenant, indicating how much they pay for the services and the frequency of pay.
Per the IRS, generally, a person is self-employed if an individual:
- Carries on a trade or business as a sole proprietor or an independent contractor
- Is a member of a partnership that carries on a trade or business
- Is otherwise in business for themselves (including a part-time business)
Individuals in business for themselves are required to file an income tax return if their net earnings from self-employment were $400 or more. A return must also be filed for all self-employed individuals who operate sole-proprietorship businesses or otherwise report income on Schedule C, regardless of whether the individual is reporting a profit or a loss. If an applicant/tenant states that they do not file a tax return, please check with your state agency to determine if the household should be denied admittance to your LIHTC property.
When an applicant/tenant’s business has been in operation for many years, two years of tax returns along with the Schedule C for each year is normally required. The applicant/tenant completes the self- employed affidavit certifying to the anticipated amount in the next 12 months. If the amount is more or less than what the tax returns support, additional documentation may be required to determine the accuracy in the certified amount.
In the case of new business, the applicant/tenant completes the self- employed affidavit certifying to the anticipated amount in the next 12 months. Management should request the prior year tax return. Management must request current copies of gross receipts (i.e. bank statements, cash receipts, customer payment logs etc), accountant statement of quarterly earnings and taxes paid if available. The same must be requested for expenses paid.
Expenses, Exclusions and Verifications
Management must include any salaries or other amounts distributed to family members from the business and cash or assets withdrawn by family members except when the withdrawal is a reimbursement of cash or assets invested in the business. When calculating net business income, management must not deduct principal payments on loans, interest on loans for business expansion or outlays for capital improvements.
An applicant/tenant may use a portion of a low-income unit exclusively and on a regular basis as a principal place of business and claim the related expenses as tax deductions, as long as the unit is the applicant/tenant’s primary residence. This expense would be included in the Schedule C as an office expense.
If the final calculation results in a negative amount, it must be included as zero on the certification.
Appendix 3 of the 4350.3 provides the list of Acceptable Forms of Verification in the following order:
Third Party – Form 1040 with schedule C, E or F; Financial statement(s) of business (audited or unaudited) including an accountant’s calculation of straight-line depreciation expense if accelerated depreciation was used on the tax return or financial statement; for rental property, copies of recent rent checks, lease and receipts for expenses or IRS Schedule E
Provided by Applicant – Any loan application listing income derived from business during the preceding 12 months; notarized statement showing Net Business Income
In all cases of this type of income source, management is expected to make a reasonable judgment as to the most accurate amount to be included in the total household income. In the LIHTC industry, dependent upon your state agency’s specific requirements, it is best practice to utilize the most conservative method to calculate anticipated income unless there is substantive evidence to support a lower amount.
Ensuring tenant files are well documented to support the income calculation reduces the risk of non-compliance.
If you have any questions regarding this or any other compliance matters, please feel free to reach out to us at any time.